Abstract
Capital budgeting, or investment decision, depends heavily on forecasts of the cash inflow and a correct calculation of the firm’s cost of capital. Given the cost of capital, i.e., the appropriate discount rate, and a reasonable forecast of the inflows, the determination of a worthwhile capital investment is straightforward. An investment is desirable when the present value of the estimated net inflow of benefits (or net cash inflow for pure financial investments) over time, discounted at the cost of capital, exceeds or equals the initial outlay on the project. If the project’s present value of expected cash flow meets these criteria, it is potentially “profitable” or economically desirable; its yield equals or exceeds the appropriate discount rate. On a formal level, it does not appear too difficult to carry out the theoretical criteria. The stream of the forecasted net future cash flows must be quantified; each year’s return must be discounted to obtain its present value. The sum of the present values is compared to the total investment outlay on the project; if the sum of the present values exceeds this outlay, the project should be accepted.
This is a preview of subscription content, log in via an institution to check access.
Access this chapter
Tax calculation will be finalised at checkout
Purchases are for personal use only
Notes
- 1.
One need consider the case of Joel Dean’s degree of necessity, in which projects must be undertaken regardless of their economic benefit (profit). Dean (1954) suggested that replacing a shop destroyed by fire could be an example of the degree of necessity, and he further suggested that you could not quantify the degree of necessity.
- 2.
The discounted cash flow approach has been widely accepted since Dean (1954).
- 3.
In a case of capital rationing, the profitability index is calculated and used. The profitability index is the project’s net present value divided by its initial cost (Brealey & Myers, 2003).
- 4.
The ACRS depreciation charges for a 3-year asset are 0.3363, 0.4445, 0.1481, and 0.0741, respectively.
- 5.
Gordon (1955) revealed that the payback period is proportional to the reciprocal of the project’s rate of profit.
-
I = Cost of the project
-
E = Earnings or savings before depreciation of the project
-
n = Number of years of the project
-
s = Scrap value at time t = n
-
k = project’s expected rate of profit
\( C\kern0.5em =\kern0.5em \frac{E_1}{1+k}\kern1em +\kern1em \frac{E_2}{{\left(1+k\right)}^2}\kern1em +\kern1em \dots \kern1em +\kern1em \frac{E_k}{a+k}\kern1em +\kern1em \frac{E_n+{S}_n}{{\left(1+k\right)}^n} \) (4)
Gordon found if one ignored the scrap value, that
$$ C\kern0.5em =\kern0.5em \sum \limits_{t=1}^n\kern0.5em \frac{S}{{\left(a+k\right)}^t} $$\( =\kern0.5em \frac{S}{k}\kern0.5em -\kern0.5em \frac{S}{k}\kern0.5em {\left(1+\frac{1}{\left(a+k\right)}\right)}^n \) (5)
where Eq. (5) is the present value of an annuity
\( k\kern0.5em =\kern0.5em \frac{E}{C}-\frac{E}{C}{\left(\frac{1}{1+k}\right)}^n \) (6)
As the life of the project becomes very large, Eq. (6) becomes
$$ k\kern0.5em =\kern0.5em \frac{E}{C} $$and the rate of profit is the reciprocal of the payback period. Furthermore, if the project life is infinite, then the rate of profit is the reciprocal of the payback period. The reader immediately recognizes the Gordon payback period analysis is consistent with the Gordon valuation of stock model shown in chapter “The Equity of the Corporation: Common and Preferred Stock.” If we buy a stock, we purchase a stream of expected future dividends. The stock price, PCS, or P0, is determined by the current dividends per share, D0, and the growth rate of future dividends, g.
\( {P}_0=\frac{D_0}{d-g} \)
where \( k=\frac{D_0}{P_0+g} \).
The rate of profits earned by purchasing stock is its current dividend yield, \( \frac{D_0}{P_0} \), plus the rate at which dividends are expected to grow, as long as k > g (Gordon & Shapiro, 1956).
-
- 6.
If a firm does not make the proper cost-of-investment determination, it could develop an unprogressive policy in regard to equipment replacement. The firm could repair its equipment long past an economic optimum because the fairly large total earnings on a repaired piece of equipment is credited just to the costs of repair. The economic investment in a reconstruction job, however, is the repair costs plus the salvage value of the unrepaired equipment. Furthermore, the forecasted cash flow should subtract the estimate of maintenance costs that may still have to be made in the future. When the problem is thus properly formulated, it may be that a replacement will show a higher rate of return than a repair job.
- 7.
In a sense, the existence of the whole firm may be periodically measured against the same criterion: how does the withdrawal value of the firm’s assets compare to the discounted value of its projected cash flow.
- 8.
The cost is not zero to the economy as a whole, but the individual firm is not concerned with aggregate economic costs at this point.
- 9.
The amount made on the asset value of the equity—especially its growth or trend over time—may, however, be a fairly good index of the firm’s economic success.
- 10.
“The Corporate Sector: A Net Exporter of Funds,” J.R. Aronson and E. Schwartz, Southern Economic Journal, October 1966.
- 11.
It should also be recognized that the accounting results and the estimated rate of return may not necessarily coincide because accounting conventions on depreciation and calculation of profits may differ from the assumptions underlying the cash flow rate of return analysis. This needs not invalidate the usefulness of either the discounted cash flow techniques or of accounting procedures.
References
Brealey, R. A., & Myers, S. C. (2003). Principles of corporate finance (7th ed.). New York: McGraw-Hill/Irwin.
Dean, J. (1954). Measuring the productivity of capital. Harvard Business Review, 32, 120–130.
Gordon, M. J. (1955). The payback period and the rate of profit. Journal of Business.
Gordon, M. J., & Shapiro, E. (1956). Capital equipment analysis: The required rate of profit. Management Science, 3(1), 102–110.
Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Finance Economics, 60, 187–243.
Lanzilotti, R. F. (1958). Pricing objectives in large companies. American Economics Review, 48, 921–940.
Lerner, E. M., & Carleton, W. T. (1966). A theory of financial analysis. New York: Harcourt, Brace, and World.
Myers, S. C. (1974). Interactions of corporate financing and investment decisions: Implications for capital budgeting. Journal of Finance, 29, 1–25.
Author information
Authors and Affiliations
Rights and permissions
Copyright information
© 2021 Springer Nature Switzerland AG
About this chapter
Cite this chapter
Guerard, J.B., Saxena, A., Gultekin, M. (2021). Investing in Assets: Theory of Investment Decision-Making. In: Quantitative Corporate Finance. Springer, Cham. https://doi.org/10.1007/978-3-030-43547-9_11
Download citation
DOI: https://doi.org/10.1007/978-3-030-43547-9_11
Published:
Publisher Name: Springer, Cham
Print ISBN: 978-3-030-43546-2
Online ISBN: 978-3-030-43547-9
eBook Packages: HistoryHistory (R0)